TAILIEUCHUNG - Exploiting Naïvete about Self-Control in the Credit Market

Due to the nonredundancy condition, the competitive-equilibrium contracts we derive exclude most options by assumption; in particular, nonsophisticated borrowers’ only option to change the repayment schedule will be to change it by a lot for a large fee. As is usually the case in models of nonlinear pricing, the same outcomes can also be implemented by allowing other choices, but making them so expensive that the borrower does not want to choose them. In fact, this is how it works in the real-life examples discussed below, where deferring even small amounts of repayment carries disproportionately large fees | American Economic Review 100 December 2010 2279-2303 http . org doi 7 aer 79 Exploiting Naivete about Self-Control in the Credit Market By Paul Heidhues and Botond Koszegi We analyze contract choices loan-repayment behavior and welfare in a model of a competitive credit market when borrowers have a taste for immediate gratification. Consistent with many credit cards and subprime mortgages for most types of nonsophisticated borrowers the baseline repayment terms are cheap but they are also inefficiently front loaded and delays require paying large penalties. Although credit is for future consumption nonsophisticated consumers overborrow pay the penalties and back load repayment suffering large welfare losses. Prohibiting large penalties for deferring small amounts of repayment akin to recent regulations in the US credit-card and mortgage markets can raise welfare. JEL D14 D18 D49 D86 Researchers as well as policymakers have expressed concerns that some contract features in the credit-card and subprime mortgage markets may induce consumers to borrow too much and to make suboptimal contract and repayment These concerns are motivated in part by intuition and evidence on savings and credit suggesting that consumers have a time-inconsistent taste for immediate gratification and often naively underestimate the extent of this Yet the formal relationship between a taste for immediate gratification and consumer behavior and welfare in the credit market remains largely unexplored and unclear. Existing work on contracting with time inconsistency DellaVigna and Ulrike Malmendier 2004 Botond Koszegi 2005 Heidhues ESMT European School of Management and Technology GmbH Schlossplatz 1 10178 Berlin Germany e-mail Koszegi University of California Berkeley Department of Economics 508-1 Evans Hall 3880 Berkeley CA 94720 e-mail botond@ . First version November 2007. We thank Stefano .